Investors, Not Consumers, Driving Oil Prices Up

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The recent rise in oil prices seems be driven by Wall Street investors — not market supply and demand.

Updated at 11:15 PM PDT on Tuesday, Mar 30, 2010

With the world economy still reeling from a deep recession and the world awash in crude, oil-producing countries have convened in Mexico to map out a strategy for keeping prices from rising higher.

The worry is that further increases could snuff out an already fragile global economic recovery. But oil producers may face an even bigger problem: The recent rise in prices seems be driven by Wall Street investors — not market supply and demand.

Though prices crashed from their peak of $140 a barrel before the recession began in Dec., 2007, they have since recovered substantially. Last year, the price of crude crashed to $33 a barrel before a relentless recovery to about $80 by year-end. Prices at the pump have been following the same upward path — from $1.84 in Jan 2009 to $2.67 by year end.

The upward trend has continued, and oil watchers at Wall Street banks are betting oil will eventually trade above $90 a barrel this year.

Part of the reason, this thinking goes, is that as the global economy recovers, so will demand for oil and gasoline.

"Overall, U.S. oil demand is definitely improving, laying the foundations for a broad-based recovery ... notwithstanding the weakness in Europe," Barclays Capital said in a recent report. "We continue to see oil prices consolidating in its current $75 to $85 range and on course to gradually move higher to $80 to $90."

But wait a minute. If the global economy is using less oil, and supplies are more than adequate, why are oil prices at $80 a barrel in the first place?

The answer, according to oil analyst Peter Beutel at Cameron Hanover, is that investors are driving the price of oil — not the people who use it.

“The sovereign wealth funds, college foundations, union pension plans — all this big vested money has been sold on the idea that ‘you’re investment portfolio is not complete without 10 percent in commodities,’ ” Beutel said.

That’s not what was supposed to happen when gasoline prices surged and drivers cut back on trips to the pump by traveling fewer miles or upgrading to more fuel-efficient vehicles.

Those conservation efforts — along with a big drop in economic activity — have had the desired effect of driving down gasoline consumption. After peaking at nearly 9.8 million barrels a day in August 2007, demand for gasoline has fallen steadily to a low of 8.5 million barrels day in Feb 2010 – a drop of 13 percent. But in the past 12 months, prices are up more than 50 percent. During that period, oil prices have more than doubled.

“People are using oil as a store of value rather than as a commodity,” said Beutel. “It’s the investors who are buying.”

Wall Street has been urging investors to snap up oil for several reasons. The huge flood of money into the financial system since the Sept. 2008 meltdown has sparked fears that inflation — though currently tame — may be ignited by too much money chasing too few goods. Worries about rising U.S. borrowing have some investors worried about the long-term value of the dollar; oil is seen as a hedge against future dollar losses.

All of which has turned oil into a hot financial instrument — even as demand for industrial uses remains tame, says Beutel.

“At this particular moment, decisions made by Ben Bernanke on interest rates seem to have more of an influence on the price of oil than decisions by made Saudi oil minister Ali al-Naimi – which is a very peculiar situation,” he said.

That peculiar situation is one of the issues OPEC officials are wrestling with this week at a meeting in Mexico as they try to figure out what to do if oil prices keep moving higher. Much of the discussion focused on how high to let oil price go before increasing production to try to dampen the ongoing rise.

"Prices above $85 for a sustained period of time could well be harmful,” one OPEC delegate told Reuters. "We have to be aware that the economic recovery is still fragile."

But there are signs the cartel’s 11 oil producers have already begun increasing supply, which was up by 200,000 barrels per day in March. Compliance with supply curbs agreed to in December 2008 has fallen to about 50 percent, according to a Reuters survey.

There’s no shortage of oil inventories, which are above their five-year average and have been rising steadily in the past three months. Gasoline stocks are also well above their five-year average for this time of year.

But that hasn’t helped at the pump. Beutel estimates that, after oil prices crashed last year, American consumers saved some $117 billion at the pump compared to what they spent in 2008. But with prices rising again, American drivers paid $20.2 billion more to fill up in the January and February than they did in the in the first two months of 2009. At that rate, consumers will take a $100 billion hit in 2010 just from higher gas prices.

“Higher oil prices — even oil prices at existing levels — represent a tax on the American consumer at absolutely the worst possible time when we’re trying to fight our way out of a recession,” said Beutel.

Higher oil prices typically encourage oil producers to bring more supply to market, and that appears to be happening. OPEC Secretary General Abdalla Salem El Badri said this week that the cartel will bring an estimated $45 billion worth of drilling projects back on line which had been shelved after oil prices fell.

But, as long as investor demand remains strong, that extra supply may do little to dampen prices.

“We would still be producing plenty of oil at $50 and give consumers a reasonable relief that would allow this economy to grow much more substantially and put us on a much firmer footing,” said Beutel.